The most important confusion concerning the meaning and
significance of the marginal efficiency of capital has ensued on
the failure to see that it depends on the prospective
yield of capital, and not merely on its current yield. This can be
best illustrated by pointing out the effect on the marginal
efficiency of capital of an expectation of changes in the
prospective cost of production, whether these changes are expected
to come from changes in labour cost, i.e. in the wage-unit, or from
inventions and new technique. The output from equipment produced
to-day will have to compete, in the course of its life, with the
output from equipment produced subsequently, perhaps at a lower
labour cost, perhaps by an improved technique, which is content
with a lower price for its output and will be increased in quantity
until the price of its output has fallen to the lower figure with
which it is content. Moreover, the entrepreneur's profit (in terms
of money) from equipment, old or new, will be reduced, if all
output comes to be produced more cheaply. In so far as such
developments are foreseen as probable, or even as possible, the
marginal efficiency of capital produced to-day is appropriately
diminished.
This is the factor through which the expectation of changes in
the value of money influences the volume of current output. The
expectation of a fall in the value of money stimulates investment,
and hence employment generally, because it raises the schedule of
the marginal efficiency of capital, i.e. the investment
demand-schedule; and the expectation of a rise in the value of
money is depressing, because it lowers the schedule of the marginal
efficiency of capital.
This is the truth which lies behind Professor Irving Fisher's
theory of what he originally called 'Appreciation and Interest'
- the distinction between the money rate of interest and the
real rate of interest where the latter is equal to the former after
correction for changes in the value of money. It is difficult to
make sense of this theory as stated, because it is not clear
whether the change in the value of money is or is not assumed to be
foreseen. There is no escape from the dilemma that, if it is not
foreseen, there will be no effect on current affairs; whilst, if it
is foreseen, the prices of existing goods will be forthwith so
adjusted that the advantages of holding money and of holding goods
are again equalised, and it will be too late for holders of money
to gain or to suffer a change in the rate of interest which will
offset the prospective change during the period of the loan in the
value of the money lent. For the dilemma is not successfully
escaped by Professor Pigou's expedient of supposing that the
prospective change in the value of money is foreseen by one set of
people but not foreseen by another.
The mistake lies in supposing that it is the rate of interest on
which prospective changes in the value of money will directly
react, instead of the marginal efficiency of a given stock of
capital. The prices of existing assets will always adjust
themselves to changes in expectation concerning the prospective
value of money. The significance of such changes in expectation
lies in their effect on the readiness to produce new
assets through their reaction on the marginal efficiency of
capital. The stimulating effect of the expectation of higher prices
is due, not to its raising the rate of interest (that would be a
paradoxical way of stimulating output - in so far as the rate
of interest rises, the stimulating effect is to that extent
offset), but to its raising the marginal efficiency of a given
stock of capital. If the rate of interest were to rise
pari passu with the marginal efficiency of capital, there
would be no stimulating effect from the expectation of rising
prices. For the stimulus to output depends on the marginal
efficiency of a given stock of capital rising relatively
to the rate of interest. Indeed Professor Fisher's theory could be
best re-written in terms of a 'real rate of interest' defined as
being the rate of interest which would have to rule, consequently
on a change in the state of expectation as to the future value of
money, in order that this change should have no effect on current
output. It is worth noting that an expectation of a future fall in
the rate of interest will have the effect of lowering the
schedule of the marginal efficiency of capital; since it means that
the output from equipment produced to-day will have to compete
during part of its life with the output from equipment which is
content with a lower return. This expectation will have no great
depressing effect, since the expectations, which are held
concerning the complex of rates of interest for various terms which
will rule in the future, will be partially reflected in the complex
of rates of interest which rule to-day. Nevertheless there may be
some depressing effect, since the output from equipment produced
to-day, which will emerge towards the end of the life of this
equipment, may have to compete with the output of much younger
equipment which is content with a lower return because of the lower
rate of interest which rules for periods subsequent to the end of
the life of equipment produced to-day.
It is important to understand the dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the trade cycle. In chapter 22 below we shall show that the succession of boom and slump can be described and analysed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.